Should I Lock In a Mortgage Rate?

Mortgage interest rates change daily. The rate that is available when
you apply for a loan may not be the rate that you see weeks or months
later at closing.

Home buyers have two choices. They can let the rate float, or they can
lock in.

What Makes a Good Lock-In Decision?

It is impossible to know with certainty whether it will be better to lock
in or float the interest rate. However, you can improve the odds of
making a correct decision.

First, you need to understand what constitutes a good lock-in
decision. Some home buyers believe that they have made a good
lock-in decision if the interest rates increase after they lock in.

This is not always correct, because it
ignores the cost of locking in. For the lock-in decision to be
correct, interest rates cannot just rise; they must rise enough
for the added interest expense to exceed the cost of locking in.

Therefore, to make an informed lock-in decision, you need to know
how much interest rates would have to rise to cover the cost
of locking in. The following case study shows how to figure
this out.

How to Compute the Costs and Benefits of Locking In

Selena is buying a new home for $300,000 - the fair market value of
the home. She will make a down
payment of $30,000, so Selena needs a $270,000 loan. She a chosen a
fixed-rate mortgage. The lender requires
private mortgage insurance (PMI)
payments of $1,800 per year.

The current interest rate is 7%. The lender will lock in that
interest rate for 1% of the loan amount (i.e., $2,700).

If she doesn't lock in, other costs (e.g., closing costs) amount to $3,000.
If she does lock in, other costs will equal $3,000 plus the $2,700 fee
to lock in or $5,700.

Selena is worried that the interest rate will rise to 7.125% if she
lets the rate float. Assume that Selena plans to live in the her
new home for 5 years. Would she be better off to lock in or let
the rate float? The details of each option appear below. (Note that the
lock-in fee shows up in the "Other costs" category. Other costs are
$3,000 when Selena lets the loan float; $5,700 when she locks in.)

Lock in at 7%

Float to 7.125%

Mortgage type:

Fixed-rate mortgage

Mortgage type:

Fixed-rate mortgage

Loan term:

30 years

Loan term:

30 years

Loan amount:

$270,000

Loan amount:

$270,000

Interest rate:

7 percent

Interest rate:

7.125 percent

Down payment:

$30,000

Down payment:

$30,000

Points:

0

Points:

0

Other costs:

$5,700

Other costs:

$3,000

To compare the options, Selena uses this site's
mortgage calculator.
The first step is to describe the analysis she wants to conduct.

Choose "Compare two mortgages" from the Main Goal dropdown box
of the calculator.

Be sure the "Show amortization schedule" checkbox is checked.

Be sure the "Include mortgage insurance" checkbox is checked.

Under Loan 1, choose "Fixed-Rate Mortgage" as the mortgage type.

Under Loan 2, choose "Fixed-Rate Mortgage" as the mortgage type.

The calculator then prompts Selena for the data it needs,
and Selena enters
data from the above description into the calculator. For the lock-in
option, Selena enters $5,700 for "Other costs", to account for closing
costs plus the cost to lock in. For the float option Selena enters
$3,000 for other costs, since she is not paying the $2,700 lock-in fee.
The calculator settings and data entries are shown below.

Describe the Analysis

Main goal:

Options:

Show amortization schedule
Include mortgage insurance
Include hazard insurance

Include property tax
Include prepayments
Include tax deductions

Describe the Loan

Loan 1

Loan 2

Mortgage type:

Loan term (in years):

Loan amount ($):

Interest rate:

Describe the Costs Paid at Closing

Down payment ($):

Points (%):

Other costs and fees ($):

Enter Tax and Insurance Info

Annual mortgage insurance ($):

Appraised value of home ($):

After Selena clicks the Calculate button, the calculator produces an
amortization report that shows the total mortgage cost for each option.
The amortization report shows the total cost for each month of the
loan. Since Selena will only live in the home for 5 years, she
focuses on the total cost at the 5-year mark (60
months).

After 5 years, the total mortgage
cost for the lock-in option (7% interest, with $2,700 lock-in fee) is
$406,634; and the total cost for the float option (7.125% interest, with
no lock-in fee) is $405,634. Conclusion: Even if the interest rate
increases to 7.125%, it will be cheaper to let the rate float than to
lock in.

But what if the interest rate at closing floated to some different
value? You can easily repeat the analysis to assess the outcome
for any interest rate. The table below shows the result at a variety
of interest rates.

Prevailing rate at closing

Total mortgage cost: Lock in

Total mortgage cost: Float

6.750%

$406,634

$400,537

6.875%

$406,634

$402,235

7.000%

$406,634

$403,934

7.125%

$406,634

$405,634

7.250%

$406,634

$407,335

7.375%

$406,634

$409,037

7.500%

$406,634

$410,740

This analysis shows that letting the rate float is the best decision, until
the rate floats to 7.25% or higher.

Conclusion

This kind of analysis gives a home buyer the information needed to make an
informed decision. In the example presented above, Selena can see that
interest rates would have to increase to 7.25% for locking in to be the
right financial choice. On the other hand, if the prevailing rate at
closing is 7.125% or less, then letting the rate float is the right choice.